When you study accounts, you are taught to pay attention to every tiny detail. Every bit of finished goods needs to be derived from raw materials, work in progress and the reach its current state. Every invoice and value has to tally up. All the small things somehow have a multiplier effect on the balance sheet and errors show up if things are missed. Unlearning this habit when developing a valuation assessment for a set-up, is not an easy process – but a necessary one.
I am not saying in any way that misrepresentation is required, simply that generic assumptions, and missing some tiny details when creating a financial model for valuation/investment purposes is perhaps more prudent and quick. Because really, for valuation, the multiplier effects of the smaller things are really minimal. The question to ask when dwelling on a small issue is – is this going to materially impact the value of the company. This is especially true for newer set ups where all the smaller elements are not necessarily tied up – and waiting just adds to frustration and inertia.
From an entrepreneur’s angle, understanding the fundamentals of what really will impact your business value goes a very long way by helping you to make sound strategic decisions prior to approaching investors. Unlocking intrinsic business value is necessary step for investment.
Simple questions like, “should the land on which the business is run be owned by the entrepreneur, the business or a third party” are often asked. This ideally requires another level of questioning i.e. is the land going to be used for financing, does the owner want a separation of his land ownership from business ownership, etc. If used for financing, then the land has to necessarily be on the books of the business. If not, then the land can be leased by the business from the owner of the land (even if it is the same as the promoter of the business). The leasing route however, means that while your land is safe and insulated from the businesses liabilities, the value of the business will be lower.
Another conundrum for valuation can be depreciation. It’s basically a book entry with no cash impact – other than the tax perspective. So essentially, when valuing a company which is either enjoying a tax holiday or does not need to pay taxes for whatever reason, the depreciation really is immaterial – it’s a book entry which needs to be factored in but not really bothered about.
“Others” can be a very useful head for new set-ups where small details can be clubbed for a quick valuation assessment of undecided items. These are usually not large enough to impact the business value in any way and involve a lot of time and effort to sort out. They are essential to the business no doubt and need to be sorted out before you start. But, can be done while valuation negotiations are underway.
Next, the king – cash. The alluring net profit line and margins which drives a lot of entrepreneurs really means very little if the cash in the business (sitting on the balance sheet) is at an unhealthy level. The two go hand in hand but the cash figure is what you really need to look out for – because that will give you your reserves to weather any storms.
Finally, keep in mind that the on paper valuation and the value you will agree to rarely coincide in any way. These valuation exercise are a starting point for discussions and the actually value most new businesses have is more intangible in nature. A Discounted Cash Flow Method (DCF) does take into account a lot of things but it is a very optimistic view on the business. On the other hand an asset valuation will lead to a close value-free assessment. Other methods such as comparable-valuation do not really apply to new businesses.
The big picture is this: A solid product backed by management confidence, trust, honesty, past record for performance in other businesses etc is what actually clinches most deals – not the excel sheet numbers. Negotiation ability of course is the icing on the cake.